Are slowing corporate profits hurting stock?

Bloomberg recently published an interesting article that I think is worth discussing.

The article, “Analysts Boosting S&P 500 Target 11 Percent Reduce Earnings Growth,” delves into the fact that U.S. corporate earnings growth has slowed substantially, yet stock market analysts are raising their stock price targets at a fast clip. Below are the highlights of the article, followed by my thoughts.

“The same equity analysts who lowered second-quarter profit growth predictions to almost nothing in 2013 are raising (stock) price forecasts, convinced that the economy is growing fast enough to lure more investors and boost valuations.

“Standard & Poor’s 500 Index earnings rose 1.8 percent last quarter, down from a projection of 8.7 percent six months ago, according to more than 11,000 analyst estimates compiled by Bloomberg. At the same time, share-price targets for companies are rising at the fastest rate in two years. The U.S. equity gauge will increase 8.9 percent to a record 1,777.91 percent, should the forecasts prove accurate.

“Bulls say expectations for higher valuations show analysts share Federal Reserve Chairman Ben S. Bernanke’s view that the economy may gather enough momentum to expand on its own. Getting to their target would raise the index’s earnings multiple to 16.4, still about 12 percent lower than its 25-year average. Bears say price appreciation without profit gains shows the five-year bull market is fading and declines are inevitable. Second-quarter earnings season begins today.

“Even as the S&P 500 rallied 60 percent during the past three years, its price-earnings ratio remained below the long-term average of 18.6, according to data compiled by Bloomberg and S&P that begins in 1988. Valuations have held steady as profit growth matched gains in share prices since the bull market began in March 2009.

“Reaching analyst price forecasts would send the S&P 500 more than 6.5 percent above the all-time high of 1,669.16 set May 21. Operating profits projected to reach a record $108.40 a share this year would give the index a valuation of 16.4, compared with 17.5 when the market peaked in October 2007.

“After three years of growth, earnings increases are slowing. Income in the S&P 500 advanced an average of 4.3 percent in each of the last five quarters, compared to the 28 percent average for 2010 and 2011, Bloomberg data show. Analysts are looking past profit growth this year and predicting improving investor sentiment will push stocks higher. They’ve boosted price estimates for the S&P 500 by 11 percent from 1,608.50 on Dec. 28, the fastest rate since July 2011, according to data compiled by Bloomberg.”

Stock prices ultimately are driven by what happens with corporate profits. When corporate profits plunged in 2008, so did stock prices.

The multiple of earnings (price-earnings ratio) that investors are willing to pay for stocks also is an important factor in what happens with stock prices. During the 2008-09 recession, as pessimism grew, the price-earnings ratio that investors were willing to pay for stocks fell. This compounded the fall in stock prices caused by lowered earnings.

During a typical bull market, stock prices rise as corporate profits spring back, which they have indeed done in the past four years. The price-earnings multiple tends to gradually expand (with investor confidence) during a bull market.

Now, the article mentions the average price-earnings multiple for the U.S. market in the past 25 years and suggests that the current rally has more room to run because we aren’t yet back to that level. However, the article failed to point out that the most recent 25-year average is skewed by a period of excess valuations in the late 1990s, driven mostly by technology stocks.

While I don’t think that the U.S. stock market is overvalued currently, I would point out that we’re getting closer to the high end of the bull market.

Corporate profits have come roaring back — more than doubling since the bear market lows in early 2009. Make sure that you are diversified in stocks worldwide, and don’t make the mistake of overloading with U.S. stocks, which have done better than most overseas markets in the past year.

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